Government and Nonprofits Experiment With New Approach on Financing

Marie-Claude Thompson, co-founder of Earthen Vessels, a Boston nonprofit, dislikes how much time she spends raising money.

She would much prefer to pour more of her time into recruiting and training new tutors to work with kids from some of the city’s toughest neighborhoods.

Society, too, might be better off if Ms. Thompson could focus more of her energy on her mission.

Nearly all of the students her group mentors not only graduate from high school but also go on to college.

But lack of money has meant Earthen Vessels, a 30-year-old group, can provide intensive mentoring to only 30 students a year.

Now a new financing effort getting attention from foundations and governments—most notably the Obama administration, which last week offered up to $100-million toward the approach—may help nonprofits like Earthen Vessels attract the money they need to expand, with the goal of saving money for society in the end.

Backers of the new financial tool, known as social-impact bonds, want to tap the discipline of the business world by enlisting investors to put up the money to run social programs that the government normally pays for.

The incentive for investors: If they back programs that get results, the government will not only repay the money but also provide a bonus.

The concept is popular because it reduces fund-raising headaches for nonprofits and because it allows the government to avoid paying for programs that don’t make a difference.

If a nonprofit fails to reduce homelessness or doesn’t increase graduation rates, for example, then the government pays nothing.

Social-impact bonds are now getting a try in Britain, in part with money from the Rockefeller Foundation.

But they are gaining momentum in the United States, too, especially now that President Obama has announced what he calls “pay for success” funds.

According to his 2012 budget, the “performance-based awards” will go toward job training, increasing college-retention rates, helping those with disabilities transition to the work force, and reducing the number of people who commit crimes after being released from prison.

The White House offered few details about the “success funds.”

But the buzz about social-impact bonds was immediate. The day after the White House announcement, the Rockefeller Foundation said it would spend $400,000 on a feasibility study to see how this new financial tool could be transplanted from Britain to the United States.

A Focus on Prevention

Those who are promoting the bonds insist the benefits are enormous.

By encouraging the growth of results-oriented social programs that end the cycle of poverty or prevent drug abuse, they argue, the country is tackling problems that otherwise would one day cost the government billions in lost wages and additional social expenditures, including building more prisons and hiring more police.

“It shifts funding towards prevention, and prevention is so much more efficient than paying for a cure,” says Kippy Joseph, associate director at the Rockefeller Foundation. “It’s actually a win for the taxpayer.”

It’s also a potential win for foundations, because grant makers could invest their endowments in the bonds.

“We are always looking for ways that capital can be used for a bigger effect,” says Ms. Joseph.

Better Monitoring

Governments have never been good at monitoring the success rates of the nonprofits they hire to provide services, says Jeffrey B. Liebman, who was deputy director at the Office of Management and Budget during the first half of the Obama administration.

Programs that don’t produce results continue to be financed year after year, something that would not happen in the business world, says Mr. Liebman, who now teaches at Harvard University’s Johm F. Kennedy School of Government.

Social-impact bonds, because they are financed by private investment, he argues, will bring the discipline of the marketplace to social programs.

“It shouldn’t take 20 years to discover that Head Start needs significant reform,” says Mr. Liebman, referring to a recent report that said the $9-billion annual federal program is not producing lasting results.

No Chicken Dinners

As to whether these bonds can deliver, the jury is still out.

A pilot program got under way last year in Britain, run by Social Finance, a group that develops financial products for nonprofits.

The test project, which received $500,000 from the Rockefeller Foundation, seeks to reduce the percentage of men in England who return to prison. Because 60 percent of those released are now sent back behind bars, Britain loses billions of dollars through direct expenses and lost economic contributions from the men behind bars.

The bond will pay returns based on the number of prisoners who are not convicted of a crime within one year after their release.

If the nonprofits that deliver housing, job training, drug treatment, and other services to former prisoners can lower the number of those convicted of another crime by 10 percent, investors stand to get a maximum 13-percent return on their $8-million investment.

The crucial aspect of the financing approach is that it allows nonprofits to spend more time doing what they do best, says Tracy Palandjian, who opened Social Finance’s U.S. office in January.

“We provide money to do their great work so they don’t have to provide chicken dinners,” she says. “We bring in growth capital to scale the work of effective nonprofits.”

Social impact bonds don’t work for every type of nonprofit, cautions Ms. Palandjian. Her group will work only where nonprofit efforts to solve a social problem have proven themselves and have the potential to save the government big money over the long run.

To achieve this, success rates must be measurable. What’s more, the people who get aid need to be objectively selected and carefully tracked.

Socially Palatable Causes

Nonprofits, even those that efficiently deliver quality programs, suspect they might not have the infrastructure or the human resources to develop complex performance measures.

Jatrice Martel Gaiter, executive vice president of Volunteers of America, which is a large provider of one of the government-financed social programs, fears that programs that serve the most needy will be left behind.

Ms. Gaiter wonders whether investors will gravitate toward supporting only socially palatable, easy-to-document ways to help the needy.

Meanwhile, society’s most difficult problems, such as homelessness and mental illness, which require a multiplicity of complex efforts to solve, will languish.

“Are we only going to fund children’s programs,” Ms. Gaiter asks, “or are we going to fund programs for abusive, alcoholic men?”

Not a Panacea

Supporters of social-impact bonds are very clear: This new financial tool is not a panacea. One analyst suggests that perhaps only 20 percent of service providers would be attractive to investors.

And once nonprofits are chosen, questions abound about who will be setting the standards for nonprofit performance and, more important, who will be measuring whether they have been met.

Alan L. Stanzler, a lawyer in Boston who advises clients on their philanthropic planning, says investment advisers such as himself, would be very wary of any financial products that tie performance to targets without knowing who is setting them.

“How are the benchmarks defined and who is making the ultimate decision of how they have been achieved?” asks Mr. Stanzler. “There would be a lot of skepticism especially if the government was making that determination.”

Such issues still need to be worked out, says Amit Bouri, director of strategy and development at the Global Impact Investing Network, a group that works to increase the amount of for-profit capital flowing to nonprofits.

The network is developing standards for the bonds that everyone can agree on and encouraging transparency when it comes to how funds define and report their performance.

With the Obama administration’s inclusion of social-impact bonds in its budget, that conversation is now getting a lot of attention.

“It’s an exciting development, says Mr. Bouri. “There are many challenges and a lot of hard work still left to be done. A commitment like this will engage new players and new capital and bring them together to bear on the challenges that are facing the country.”